OPEC Meeting Aftermath: Cut Fatigue Setting In

OPEC+ have opted to deepen their production cuts, from 1.20mn b/d to 1.70mn b/d. However, with the group having cut output by around 1.58mn b/d as of October, in practice this represents little more than a rollover of the current deal.

More significant was the commitment made by Saudi Arabia to continue in its overcompliance, to bring the total cut to 2.1mn b/d, further growing the kingdom’s already overweight role in the deal.

We had expected the current deal to be rolled over until the end of 2020, but the group has instead opted to leave the deal’s expiry set at March. Nevertheless, we believe it is highly probable that the deal will be rolled over at this stage.

Despite the deepening commitment to the cut, we see several signs that policy action by OPEC is becoming increasingly fatigued. This is indicated by the smaller cuts pledged and the number of ‘sweeteners’ needed in order to build consensus.

The key question is whether laggards, notably Iraq, will meaningfully alter their compliance in the coming months. Overall, compliance is likely to remain patchy, although we do not believe this will trigger a breakdown of the deal.

Even assuming 100.0% compliance is met across the group, the effective cuts to be made by OPEC+ will fall far short of the cuts that are needed in order to balance the market next year. We maintain our view that oil prices will decline y-o-y in 2020.

OPEC+ have opted to deepen their production cuts, from 1.20mn b/d to 1.70mn b/d. On paper, the impact on the market balance for 2020 should be significant. However, as of October, the group had already cut by around 1.58mn b/d, implying only 120,000b/d more will be taken offline, should compliance with the new deal reach 100.0%. Furthermore, the terms of the deal have been amended so that, for Russia, only crude will be included in the quota and not condensates. This will bring the October cut to comfortably above 1.60mn b/d, further eroding the net impact of the decision taken on December 6.

More significant was the commitment made by Saudi Arabia to continue in its overcompliance, to bring the total cut to 2.1mn b/d. The kingdom has pledged to reduce its output to 9.74mn b/d, down from its October 2018 reference of 10.63mn b/d. However, it has nominally conditioned that pledge on more even compliance within the rest of the group. In October, the kingdom’s compliance sat at 231.0%, substantially above the 132.0% for the OPEC+ group as a whole. The disparity is even starker in volume terms, with the group cutting by around 380,000b/d more than the agreed amount, while the excess cut by Saudi Arabia alone stands at 420,000b/d. Historically, the kingdom has always shouldered a heavy burden in OPEC, but its overweight role in the deal is continuing to grow. Based on five-year averages, Saudi Arabia represents just shy of 25.0% of the group’s production, but will now contribute around 43.0% of the 2.1mn b/d cut. Should compliance with other members remain patchy, its share could easily balloon towards 50.0%.

Saudi Losing Patience With Patchy Compliance

October Compliance With OPEC Production Cut Deal, In Volume ('000b/d) & Percentage*

We had expected the current deal to be rolled over until the end of 2020. However, the group has instead opted to leave the deal’s expiry set at March and has planned an additional meeting that month, to decide its fate. We believe that Saudi Arabia has pushed for this outcome, in order to ratchet up the pressure on other members to improve their compliance. It is also possible that there was a preference for the greater flexibility afforded by a shorter deal term, giving scope to return some cut barrels to market, should prices allow it. That said, unless there are signs of a meaningful and sustained tightening in the oil market and an accompanying run up in prices, we believe it is highly probable that the deal will be rolled over beyond Q120. Any roll back on the cuts absent these conditions would likely be viewed as an unravelling of the deal and would have a heavily bearish impact on Brent.

The key question is whether laggards, notably Iraq, will meaningfully alter their compliance in the coming months. Russia’s compliance has also been patchy, but the adjustment to include only crude oil and not condensates within the deal will largely redress this. For the group as a whole ex-Saudi Arabia, we expect some improvement in compliance, driven by members such as Nigeria and the UAE. For Iraq specifically, the scope for deeper cuts may be limited. Political uncertainties have increased in the wake of the resignation by Prime Minister Adel Abdul Mahdi and policymaking will likely suffer in the near term (see ‘Quick View: Iraqi PM’s Resignation Will Not Solve Political Crisis’, December 2). The fracturing of the country’s oil policy between the Kurdistan Regional Government and Baghdad adds further complications, especially in light of the strong growth being registered in the Kurdistan region. As such, we are unlikely to see a major reversal in compliance by Iraq.

Nevertheless, it is our view that Saudi Arabia will likely both continue with and over-comply with the cut deal beyond March. Should they opt out of the deal, the result would almost certainly be a collapse in the oil price. This would severely damage government revenue in the kingdom, although they at least have in place the fiscal buffers to withstand such a collapse, to an extent that many other members do not. The Aramco IPO could add further incentive to hold to the deal, although the impact of oil prices and production on revenues is likely to remain the overriding concern. The change of energy minister from Khalid al-Falih to Prince Abdulaziz bin Salman has raised some uncertainties over future Saudi oil policy, although the new minister's approach to OPEC and the cut deal appears to be broadly unchanged from his predecessor's.

Producers Feeling The Pinch

Middle East & Russia Budget Balance, 2020f, USDbn

Despite the deepening commitment to the cut, we see several signs that policy action by OPEC is becoming increasingly fatigued. For one thing, the scale of the cut (500,000b/d) is the smallest of the three that have been agreed since the price collapse in 2014. The first cut (effective January 1 2017) pledged a 1.8mn b/d reduction and the second (effective January 1 2019) a 1.2mn b/d reduction. Based on oil prices, global demand and oil supply growth outside of OPEC (see chart below), it is difficult to make the case for why the cutback in 2020 will be so much smaller than the cut made in 2019.

Fundamentals Demand A Deeper Cut

*OPEC+ = OPEC+ and Libya, Venezuela and Iran. **price 'Prior To Deal' is the weekly close in the last week preceding the OPEC meeting in which the cut deal was agreed; 'Annual Average' is the average in the year in which the deal was agreed, e.g. 2017 = average in 2016. e/f = Fitch Solutions estimate/forecast. Source: Bloomberg, Fitch Solutions

As we have already said, the shorter duration of the deal will allow Saudi Arabia to apply greater pressure on the other participants, as will conditioning their own continuing overcompliance on improved compliance elsewhere. But it is hard to argue that it would not have been in the kingdom’s interest to formalise the cuts at 2.1mn b/d on a pro rata basis. As such, we question whether – should the kingdom have wanted it – there would have been consensus for a deeper cutback. Russian oil majors in particular have expressed growing frustration at the constraints imposed on them under the deal and the adjustment in their quota (to exclude condensates) was likely a prerequisite of their renewed commitment to it.

The rationale for deeper cuts is becoming less clear. Including the volumes that are being shut out of the market under US sanctions on Venezuela and Iran and with the new cuts in place by OPEC+, around 4.0mn b/d of supply will now be sitting on the sidelines of the market, waiting for a point of re-entry. To put this in context, that is equivalent to around three to four years of global oil demand growth. Absent an increase in natural decline rates, a sharper-than-anticipated slowdown in US shale or a major rebound in demand, the group already faces significant challenges in returning those cut barrels, without triggering a relapse in the price (see ‘OPEC Meeting Primer: Caught Between A Rock And A Hard Place’, November 28).

2020 Production Set To Stabilise

We also see diminishing returns to the cuts. The cuts made in 2017 were far more effective in reviving prices than those made in 2019 and, in light of a slowing global economy, ongoing trade disputes, challenges to the global autos sector and structurally bearish sentiment towards oil, it will become increasingly difficult to chalk up substantial further gains. There may also be some concern as to the impact of significantly and sustainably higher prices on US shale spending and production. The outlook on OPEC policy is clearly highly dependent then on the path of future oil prices. Our own view assumes prices remain broadly within the USD50-70/bbl range next year. A relapse in prices back towards their 2016 lows would change the calculus for the group.

Even assuming 100.0% compliance is met across the group, the effective cuts to be made by OPEC+ will fall far short of the cuts that are needed in order to balance the market. Our data point to a significant loosening in the global oil market in 2020. We estimate that global liquids supply has contracted by around 700,000b/d on average this year; next year we forecast net gains of more than 1.3mn b/d (depending on compliance with the new cut). Additionally, much of this growth is front-loaded, including Q1 ramp-ups in Norway, Brazil, Guyana and the US. Demand growth should strengthen, but only marginally – in a range of around 350,000b/d. As such, in the absence of a much sharper-than-anticipated slowdown in the US shale patch or a shock from the implementation of the International Maritime Organisation’s 2020 sulphur cap, this suggests the market will be in deep oversupply next year, leading to meaningful builds in inventories and y-o-y declines in the price. In this sense, the outcome of the meeting has not materially altered our view on either market fundamentals or prices heading into the new year (see ‘Brent: Gradual Demand Recovery Insufficient To See Prices Higher, December 3’).